Fiscal Policy Beyond Election Day: Nine Challenges For '09

When Americans go to the polls on
November 4, they will elect a president who will inherit an array of fiscal and
economic challenges greater than any new administration has faced since 1933.
In his Inaugural Address that year, Franklin Roosevelt famously reassured
Americans that, “the only thing we have to fear is fear itself.” In 2009,
either John McCain or Barack Obama will be looked to for similar inspiration.
Roosevelt’s words provide a useful guide. Fear is neither inspiring, nor
effective. The next president must be brave enough to confront our challenges,
explain them clearly to the American people, and achieve consensus on
meaningful solutions.

The outlook is formidable. Economic
growth is projected to be flat in 2009, if not in reverse. Job losses are
mounting. Incomes are being squeezed, and the personal saving rate has fallen
to zero. In the absence of domestic savings, we are borrowing heavily from other
nations. The budget deficit is approaching dangerous levels. The baby boom
generation is on the verge of retirement, putting additional strains on the
budget. Health care costs are projected to continue growing faster than
incomes, even as 46 million Americans go uninsured. War costs are rising as tax
cuts worth trillions of dollars are scheduled to expire in 2011. The
Alternative Minimum Tax threatens to ensnare tens of millions of new
households. Mortgage giants Fannie Mae and Freddie Mac have been taken over by
the federal government which has also assumed an 80 percent stake in insurance
giant American International Group (AIG). To top it off, the new president will
have to figure out how to deploy $700 billion approved by Congress to prop up
struggling financial institutions, unlock credit markets, and rescue the
economy.

No matter who wins the presidency,
campaign promises will bump up against reality. Senator McCain has promised a
spending freeze on non-defense appropriations and full extension of the Bush
tax cuts. Yet, a spending freeze seems inappropriate in the face of a deepening
economic slump, and full extension of the tax cuts beyond their December 31,
2010 expiration date, without offsets, would increase deficits and debt in the
long-term while doing nothing to provide short-term stimulus.

For his part, Senator Obama promises a
major expansion of health care coverage while opposing an idea for helping to
pay for it that is supported by many economists on both sides of the partisan
divide--altering the exclusion of health care benefits from taxation. He also
promises higher spending on energy and education while cutting taxes for 95
percent of working Americans. Even if offsets were found for these investments
as Obama promises, they would leave the budget on an unsustainable track.

On November 4, the time for campaigning
will be over, and the time for transitioning to a new administration will
begin. Whoever wins must have the flexibility to adapt. This does not mean
sacrificing principles. A President McCain can still emphasize the importance
of low taxes and low spending. A President Obama can still emphasize the need
for new domestic investments. However, they will not be writing on a clean slate.
Other presidents, most recently George H. W. Bush and Bill Clinton, recognized
the need to alter their campaign promises once it became apparent that
circumstances warranted a shift. McCain and Obama should remain open to this
possibility as well and begin preparing for it in their public pronouncements.
History has not been kind to presidents who stubbornly cling to preconceived
agendas.

Given how rapidly events are moving,
including the changing nature of the current administration’s policies, it is
fair to grant the candidates some leeway in how they respond on the campaign
trail. It is not too much to ask, however, that they honestly confront some
basic fiscal policy challenges.

The following are nine fiscal policy
challenges that will test the next president in ‘09 and beyond.

1. The financial crisis and its spillover into the
broader economy has become the top agenda item for the new administration,
regardless of prior campaign promises.

Even before it became apparent that the
federal government would take on increased responsibilities, and a substantial
amount of new debt, to deal with the current financial crisis, Senators McCain
and Obama were proposing new policies that were unaffordable. These proposals
appear increasingly unrealistic. For one thing, they are very costly--either
in terms of higher spending or lower revenues--and do not seem appropriate
given that we may face a deficit of $1 trillion or more in 2009. Equally as
important, they would require a level of time and attention that must instead
be devoted to reviving the economy and stabilizing the financial markets.
Recent legislation has devoted at least $700 billion to this task. While the
Bush Administration will begin the process of implementing this legislation, it
will be up to the new administration to carry out its main objectives.

And the task doesn’t end there. Major
questions remain about the government’s future role in Fannie Mae, Freddie Mac,
and AIG, to say nothing about the broader regulatory reform proposals that will
flood the Capitol in response to what has happened. Finally, the broad
consensus that led to swift passage of a stimulus bill in 2008 has broken down.
There is a very real possibility that conflicts over the timing and substance
of a new fiscal stimulus bill will run into the next administration. No effort
should be wasted on agenda items that do not contribute to short-term fiscal
stimulus or long-term fiscal stability. Permanent tax cuts and permanent
spending initiatives can wait.

Both Senator McCain and Senator Obama have
responded to the latest adverse developments in the financial sector with
various proposals designed to inject federal government funds into the economy.
The House Democratic leadership has also called for deficit-financed fiscal
stimulus of $150 billion to $300 billion (a larger stimulus than the one
earlier this year), and Federal Reserve Board Chairman Ben Bernanke has said
that fiscal stimulus “should be significant.”[1]

The objective of such proposals is to immediately
keep funds flowing into the economy to prop up consumption and avoid a deep
recession (see #3 below). But because these proposals would be
deficit-financed, they would increase government debt and decrease national saving. Thus, the federal government’s immediate
response will likely run counter to the longer-term goal of promoting economic
growth through more adequate saving and investment.

It is critical that the next president set
clear priorities and be willing to make tradeoffs, so that the policies pursued
over the next several years get us back on the path of higher national saving and a stronger economy. We can’t afford to
focus only on the present. Beyond the current crisis in the financial sector
looms the growing cost of Medicare and Social Security. The deficits projected
under current law, and their adverse effect on savings, investment and economic
growth, are very real. Call it a fiscal crisis or a health care crisis, the
bottom line is the same: current spending promises cannot be financed at
today’s level of taxation. No amount of fiscal stimulus will change that
because it is a structural, not a cyclical, problem. We cannot assume a
perpetual inflow of cheap foreign capital to finance our standard of living,
nor should we want to. Eventually, we will find ourselves paying higher
interest rates to attract such capital, and the resulting mortgage on future
national incomes will diminish American standards of living for generations to come.

That is why the best policy response is to combine
short-term stimulus with long-term discipline. There is nothing inconsistent in
this. If properly designed, fiscal stimulus will not have an adverse impact on
economic growth over the long term, and long-term discipline will not have an
adverse impact on economic activity in the short term. We don’t need to
sacrifice one to achieve the other, and we need to be clear about the
trade-offs -- starting now.

3. Fiscal stimulus should maximize bang for the buck.

Many economists are currently calling for
additional “fiscal stimulus.” The purpose of such stimulus is to immediately
encourage demand-side activity in the economy--to boost, or at least prop up,
the consumption of households and the purchases of businesses in order to
reduce the risk of a severe, prolonged recession. Economists point out that
short-term fiscal stimulus must increase the budget deficit, because if the tax
cuts or spending increases in the stimulus package are offset by other tax
increases or spending cuts, the net effect on aggregate demand would be largely
wiped out.

However, the good case for additional,
deficit-financed fiscal stimulus does not justify abandoning fiscal
responsibility. Tax cuts or public spending increases that are intended to
stimulate demand in the short term ought to satisfy the “timely,
targeted, and temporary” criteria to maximize the economic bang for the buck.
“Fiscally-responsible stimulus” is not an oxymoron. Fiscal responsibility in
any deficit-financed fiscal stimulus means avoiding tax cuts or new spending
that are not likely to generate much additional, immediate consumer and
business spending, by appropriately targeting dollars to those households and
businesses who are currently most constrained and hence most likely to spend
the cash flow from the stimulus. Fiscal responsibility in any deficit-financed
fiscal stimulus also means not committing to permanent deficit-financed policies that would place large,
unsustainable demands on the federal budget beyond the period when demand-side
stimulus is needed, which would undermine longer-term economic goals.

The case for short-term fiscal stimulus is
different from the case for longer-term investments. Over the longer run, the
strength and resiliency of the U.S. economy will depend on our ability to
increase national saving—to increase our “means” as a way to make “living
within our means” easier. We cannot simultaneously encourage both consumption
and saving—they are opposites. We can, however, encourage consumption in the
short term without reducing saving over the longer term, and we can deficit
spend today in smart ways so that the
budgetary cost is minimized and the economic benefit maximized.

4. Two problems that led to Wall Street’s crisis --
lack of transparency and over-reliance on debt -- are problems
for the federal budget as well.

While dealing with the financial crisis, the next administration should
begin to address the fact that the federal budget is itself suffering from a
similar over-reliance on debt and lack of transparency that doomed the
institutions the government is now forced to rescue. In recent years official
budgets have used a number of familiar scoring tactics that understate
likely expenses and overstate likely revenue. Tax cuts are enacted with “sunsets” to hide the long-term revenue cost of
making them permanent. War spending is assumed to disappear after the latest
supplemental spending bill spends out. Phantom savings are achieved by assuming
that Medicare physician reimbursement rates will be slashed. It is becoming
increasingly diffcult to know where the budget is headed, even in the
short-term, by looking at official documents.

Of more concern, however, is that the
budget process is stacked against long-term planning. A five or 10-year budget
window may have been adequate when most federal spending was appropriated
annually. It is insufficient now that so much of the budget consists of
entitlement programs rising on autopilot. A window of 30 or 40 years is needed
to establish a reasonable expectation that our fiscal policies are sustainable.
And yet, nothing requires Congress to review the current-law outlook beyond the
next few years, much less take corrective action. Every corporation in America
must account for and defray the cost of its long-term commitments. But the
federal government does not, even though its commitments are thousands of times
larger than those of any corporation. A necessary corollary to the debate over
spending and tax policy is the need to inject greater transparency and
accountability into the budget process. Without a mechanism to establish
priorities on the record, everyone can continue to ignore the long-term
consequences of current policy. With it, they must begin to talk concretely
about the size and shape of the government they want—and to budget accordingly.[2]

5.
Current fiscal
policy is already on an unsustainable track.

Official sources and independent
analysts of diverse perspectives are united in warning that our nation’s
overall fiscal policy is unsustainable. And yet, for the most part, both
candidates have avoided any discussion of the issue. We need to learn from Wall
Street’s problems: corrective actions are more
effective and much less costly if taken in advance of a crisis rather than in
the face of one. The structural imbalance between
future benefit promises and the revenues projected to pay for them must be
addressed head-on. A realistic strategy will require reductions in promised
benefits, higher revenues, or a combination of both. Everything must be on the
table.

Some will argue that
the federal government both tax and spend at about 18 percent of the Gross
Domestic Product (GDP), while others might argue that it should tax and spend
at about 25 percent of GDP. No reasonable person, however, would argue
that the government should permanently tax at 18 percent and spend at 25
percent. The resulting annual deficits and accumulated debt would shatter
the economy. Yet, this is the future we will get if we try to fund the spending
required by current law with today’s level of taxation. It is a prospect that
weighs most heavily on our children and grandchildren.

6.
Health care
reform must reduce the growth in costs.

Achieving
a sustainable fiscal policy will require us
to slow the growth rate of health care costs. Medicare costs
are projected to grow faster than the economy, and faster than can be
reasonably supported. Both candidates have made health care reform a
centerpiece of their policy agenda. However, much of the talk by the campaigns
focuses on expansion of health care coverage. While this is an important goal,
it would not, by itself, lower health care costs or their rate of growth. Yet,
expanding coverage, as a politically popular reform, might provide the momentum
for other health care reforms that could slow cost growth. This linkage between
broader coverage and tough cost control will be crucial for those seeking a
fiscally responsible path for the federal budget.

Spending
on health care will continue to increase unabated so long as we pretend that
costs can be controlled without any sacrifice. Costs are not rising because of
the proliferation of completely useless medical services. They are rising
because medical science can do more for more people—and because what it can do
is often very expensive yet always in demand, even if the benefit is
incremental or nonexistent. To control these costs we need information about
the benefits we receive from new procedures and technologies, and we need to
come to grips with the need to set limits once we have such information.

Cost
pressures from health care are felt in both the private sector and in public
programs. The business community already views health care reform as a crucial
component in their continued ability to compete in the global economy. And
there is no question that if Medicare spending grows as currently projected,
the government will be forced to take on unprecedented levels of debt and put
the nation’s standing as an economic superpower at risk.

Ultimately our nation must decide
what level of health care we wish to provide as an entitlement and how much we
are willing to pay for it. Medicare is a leader in the health care system,
accounting for 20 percent of total spending. If the next President, with the
help of Congress, can agree on meaningful Medicare reforms, it may well lead
the way for necessary reforms of the broader health care system. But even if
the next President instead chooses to focus on expanding health coverage first,
including a substantial initiative to restrain cost growth is critical.

7.
Eventually, we
are going to need more revenues.

Low rates of taxation generally
encourage economic activity by raising the returns to work, saving and
investment. Tax policy, however, should not be considered in isolation in
determining the “right” level of taxation. Treating
taxes and spending as “separate deals” is an economic fantasy. If taxes fall
too far below spending for too long, the resulting deficits will eventually
cancel out whatever positive economic effect there may be from low taxes. In
the final analysis, revenues must be sufficient to pay for the cost of
government. Debt is not a painless alternative to taxation.

The most effective long-range solutions would have to involve constraints in
the growth of Medicare and Social Security. This will require politically
difficult choices regarding who should receive benefits, what level of benefits
can be provided, and how those benefits should be delivered. But it is
unrealistic to believe that with the demographic forces in play, entitlement
spending as a share of the economy could possibly be held constant. Given the
severe upward pressures on federal spending associated with the aging of the
population and rising health care costs, it is clear that with even the best
efforts to damp down entitlement spending, the federal government will need to
look to the tax side of the budget to provide at least part of the solution to
our long-term fiscal gap.

Neither candidate has been realistic
with regard to revenues. Both are promising tax cuts that would leave the
budget far out of balance even when the economy recovers, despite their claims
about the deficit reduction they would achieve.[3] The Tax Policy Center estimates that
federal revenues in 2013 would be 18.1 percent of GDP under Obama’s tax
proposals and 17.4 percent of GDP under McCain’s tax proposals.[4]
Both are proposing a level of revenues well below
the current-law baseline of 20.1 percent of GDP in 2013, which assumes that
expiring tax cuts are not extended or the cost of any extensions fully offset.[5]
Indeed, both candidates' tax proposals lead to revenue levels below the 40-year historical average of 18.3 percent of GDP—a level
of taxation that has persistently fallen short of paying for even current demands on the federal budget,
let alone the growing demands we will face in the coming years.

Contrary to what the candidates have proposed for tax policy over the next
several years, revenues as a share of the economy will eventually have to rise
above their historical average, to come closer to matching the level of federal
spending. Economic efficiency requires that taxes be held relatively stable at
a level sufficient to pay for public spending in all future years, regardless
of whether this leads to surpluses or deficits in any given year. It makes no
sense to cut taxes today if that cut will only necessitate raising taxes (by
many-fold) tomorrow.

The new President and Congress will face an “action
forcing event” regarding tax policy almost immediately: the expiration of the
2001 and 2003 tax cuts on December 31, 2010. This will likely be the first real
test of fiscal courage for the next President, and the timing of the test might
be just right. Our economy will hopefully be past the cyclical downturn by the
time decisions need to be made about the expiring tax cuts in terms of what
should be kept, what should expire, what should be changed/reformed, and how
any revenue losses relative to complete expiration will be paid for. The
expiration of the tax cuts combined with a recovering economy should force
policymakers, faced with the reality of a growing fiscal shortfall, to seek a
more sustainable revenue policy going forward. Ideally, they would look to
reform the federal tax system in ways that improve economic efficiency, enhance
the revenue take, and achieve the desired degree of progressivity at the same
time. Increasing
revenues as a share of the economy need not discourage economic growth if done
in the spirit of fundamental tax reform. To the extent that the tax system can
be made more efficient by broadening its base--through closing loopholes,
reducing tax entitlements, and newly taxing activities that generate social
costs--marginal tax rates on productive activities would not have to rise by as
much.

8.
Over the longer
term, we need to save more and consume less.

The fundamental, pervasive problem in today's
economy as a whole is that we have been living beyond
our means. To get the U.S. economy
back on a sustainable path, not just over the next few days, weeks, or months,
but over the next several years, the U.S. needs to save more, not less--and both publicly and privately. A more
adequate level of national saving is critical for the future productive
capacity of our economy and our future standards of living. While it is
generally good that our economy remains attractive to foreign investors, an excessive
reliance on foreign capital to fund investments in our economy means an
excessive portion of the return on those investments must be repaid to those
foreign investors.

Temporary, deficit-financed fiscal stimulus may be
justified to keep the economy “alive,” but we should avoid enacting permanent proposals that encourage consumption over saving—the same
bad behavior that got us into trouble in the first place. Deficit spending
(which represents negative public saving), even if now justified as an immediate
“life support” measure, is tolerable beyond the present crisis only if it does
not jeopardize that longer-term economic goal of increasing our future “means.”

Looking beyond the current crisis, policymakers
must reexamine their longer-run fiscal policy proposals to determine if any longer-run deficit spending really makes
sense from a net benefit perspective. Even worthwhile and badly-needed
investments in education, health care, technology, and infrastructure involve
substantial up-front costs and do not necessarily pay for themselves even over
the longer run. Evaluation of the net benefits of such investments must
recognize that a choice to deficit finance them would (perhaps needlessly)
bring enlarged budget deficits and the indirect costs associated with decreased
national saving and reduced economic growth--costs that might largely offset the
intended direct economic benefits of those investments.

9.
We need to budget as if it matters -- because it does.

Failure to make tough budgetary choices in the
past combined with a sharp economic downturn makes balancing the budget an
unrealistic goal for the next few years. But the current economic crisis
and the $700 billion rescue plan cannot be used as an excuse for continued
overextension of the federal budget or continued lack of prioritizing in how
fiscal policies determine the allocation of now even scarcer
resources. Our economy’s limits need to be recognized--not just on Wall
Street, and not just on Main Street, but also in the halls of government. For the
federal government, recognizing those limits means we need to behave as if the
longer-term budget constraints are binding. Decisions on which fiscal policies
to pursue must weigh social costs against social benefits, giving priority to
the actions that score highest in their net benefits and jettisoning proposals
that score poorly. In other words, the government needs to start budgeting as
if it matters, because as American households and businesses have learned from
their recent first-hand experience, it does.

There is nothing unique about a
president having to shift priorities in the face of changing circumstances,
even when it means altering campaign promises. In 1916, Woodrow Wilson pledged
to keep us out of war only to find that it was not possible for the United
States to remain neutral in a global conflict. In 1932, Franklin Roosevelt
campaigned as a balanced budget fiscal conservative but went on to father the
New Deal. More recently, George H. W. Bush recognized the need to abandon his
“no new taxes” pledge when it became untenable, and Bill Clinton dropped his
middle class tax cuts in favor of a deficit reduction agenda.

Senators McCain and Obama have proposed
ambitious new tax and spending initiatives. Their most recent proposals are
touted as either short-term fiscal stimulus for the slumping economy, or
enhancements to the Bush Administration’s efforts to prop up the financial
markets. However, their core proposals, which remain unchanged, would
contribute to higher deficits in the future rather than immediate fiscal
stimulus or stability in the financial markets.

It is understandable that during the
presidential campaign the American people would hear only of the benefits of
candidates’ proposals and not of the costs. And the campaign talk has been
helpful in sketching out the rough outlines of two very different approaches to
fiscal policy. But whether it is President Obama or President McCain, the next
president will confront the reality of real economic
and budgetary constraints--not just
political ones--on how quickly and vigorously he can push through the agenda he
promised while campaigning. The next president should weigh the costs and
benefits, and thoughtfully prioritize and maybe re-prioritize his plans. For the sake of
the U.S. economy and the well-being of future generations, we cannot give up on
fiscal responsibility, especially not now.